In the US, 401(k) holders of employer stock can reduce taxes in retirement
In the United States, employees who hold shares of their employer in a 401(k) retirement account may, under certain conditions, use the net unrealized appreciation (NUA) tax treatment. It allows gains in the value of such securities to be taxed at long-term capital gains rates rather than as ordinary income. As MarketWatch reports, this option may be more advantageous than transferring all assets from a 401(k) to an individual retirement account (IRA).
How NUA works
With a standard withdrawal from a 401(k), the entire amount is taxed as ordinary income. Under the NUA treatment, the owner pays this tax in the year of asset distribution only on the price at which the shares were purchased. Their increase in value is taxed after the securities are sold at long-term capital gains rates of 0%, 15%, or 20%.
The publication gives an example of two employees with $400,000 in employer stock purchased for $60,000. If the entire amount is transferred to an IRA and then withdrawn at a 24% ordinary tax rate, the tax could amount to about $96,000. If NUA is used, the $60,000 cost basis will be subject to ordinary tax, while the $340,000 gain will be taxed when the shares are subsequently sold.
In MarketWatch’s calculation, a married couple using the standard deduction may sell the shares in portions over three years. Under the conditions given in the example, the gain may fall under the zero long-term capital gains tax rate. This outcome depends, among other things, on other income, pensions, and the timing of applying for Social Security benefits.
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Conditions and limitations
To use NUA, the shares must be transferred without being sold to a taxable brokerage account. If the retirement plan first sells the securities and pays the participant cash, eligibility for this treatment is lost. One of the specified events is also required: termination of employment, reaching age 59.5, disability, or death.
The distribution must be a lump sum: all assets from plans of this type with one employer must be withdrawn within one calendar year. A partial withdrawal in the same year, including a hardship distribution or an offset of loan debt, may eliminate the possibility of applying the rule.
When the strategy is not beneficial
NUA is not automatically suitable for all holders of corporate stock. If its original cost is close to the current price, the owner will have to immediately pay ordinary tax on a larger portion of the amount, while the benefit of lower taxation on the gain will be small. In addition, states may tax this gain as ordinary income regardless of the federal approach.
Before arranging distributions, MarketWatch advises asking the plan administrator about the cost basis of shares by individual lots, the possibility of transferring the securities without selling them, and the existence of other retirement plans with the same employer.
